Common Equity Tier 1 (CET1)

Allocated Loss Adjustment Expenses (ALAE)

What is Common Equity Tier 1 (CET1)?

Core Tier 1 capital (CET1) is a component of Tier 1 capital composed primarily of common shares held by a bank or other financial institution. It is a capital measure that was introduced in 2020 as a preventive measure to protect the economy from a financial crisis. All banks are expected to meet the required minimum CET1 ratio of 4.50% by 2019.

Understanding Common Equity Tier 1 (CET1)

Following the 2008 financial crisis, the Basel Committee formulated a reformed set of international standards to examine and monitor the capital adequacy of banks. These standards, collectively called Basel III, compare a bank’s assets with its capital to determine if the bank could withstand a crisis.

Banks need capital to absorb unforeseen losses that arise in the normal course of business. The Basel III framework tightens capital requirements by limiting the type of capital a bank can include in its different capital levels and structures. The capital structure of a bank consists of Tier 2 capital, Tier 1 capital and Tier 1 core capital.

Key points to remember

  • Level 1 common shares cover the most obvious shares held by a bank, such as cash, stocks, etc.
  • The CET1 ratio compares the capital of a bank to its assets.
  • The additional category 1 capital is made up of instruments which are not ordinary shares.
  • In the event of a crisis, equity is first drawn from Tier 1.
  • Many stress tests against banks use level 1 capital as a starting measure to test a bank’s liquidity and its ability to survive a difficult monetary event.

Calculation of first category capital

Category 1 capital is calculated as CET1 capital plus additional category 1 capital (AT1). Core Tier 1 capital includes the basic capital of a bank and includes common shares, excess shares from the issuance of common shares, retained earnings, common shares issued by subsidiaries and held by third parties and the combination of other comprehensive income (AOCI).

Additional Tier 1 capital is defined as instruments which are not ordinary shares but which can be included in this level. An example of AT1 capital is a potential convertible or hybrid security, which has a perpetual duration and can be converted into equity when a triggering event occurs. An event leading to the conversion of a security into equity occurs when the CET1 capital falls below a certain threshold.

CET1 is a measure of bank solvency which measures the capital strength of a bank.

This measure is best captured by the CET1 ratio, which measures a bank’s capital relative to its assets. Since all assets do not present the same risk, the assets acquired by a bank are weighted according to the credit risk and the market risk that each asset presents.

For example, a government bond can be characterized as a “risk-free asset” and receive a risk weight of zero percent. In contrast, a subprime mortgage can be classified as a high risk asset and weighted at 65%. According to Basel III capital and liquidity rules, all banks must have a minimum CET1 to weighted assets ratio (RWA) of 4.50% by 2019.

Tier 1 core capital = Tier 1 core capital / risk-weighted assets

The capital structure of a bank consists of the lower 2, upper 1, AT1 and CET1 levels. CET1 is at the bottom of the capital structure, which means that in the event of a crisis, the losses suffered are first deducted from this level. If the deduction results in a drop in the CET1 ratio below its regulatory minimum, the bank must raise its capital ratio to the required level or risk being exceeded or stopped by the regulators.

During the reconstruction phase, regulators can prevent the bank from paying dividends or bonuses to employees. In the event of insolvency, equity holders bear losses first, followed by holders of hybrid and convertible bonds and then Tier 2 capital.

In 2020, the European Banking Authority carried out stress tests using the CET1 ratio to understand the amount that would remain in banks in the event of a financial crisis. The tests were carried out during a troubling period when many eurozone banks were struggling with huge amounts of NPLs and falling stock prices. The test result showed that most banks could survive a crisis in 2020.

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